Alternative joins the conventional

Alternative investments once represented a radical departure from convention as funds sought to extract alpha, but the latest evidence suggests they are becoming an increasingly mainstream option.

According to Samuel Mann, head of alternative product distribution at Deutsche Asset Management, alternative investments are losing their mystique.

“People are becoming increasingly comfortable with them as mainstream investment vehicles,” he said. “Uncertainty over share market returns, both long and short-term, has driven investors to look for alternative forms of return, but there have been multiple factors responsible for the increased usage alternative investments are receiving.”

Neil Cassidy, general manager of Tasmanian-based superannuation fund Tasplan, identifies improved availability of alternative products and the greater maturity of several alternative investments as also being key drivers behind alternatives’ increased popularity.

“It’s hard to put portfolio diversification aside when it comes to alternative investments, as it is the main driver,” he said. “Related to diversification, however, is the investors’ need to reduce investment volatility, especially on the downside experienced in the equity market.”

The recent surge in popularity of alternative investments seems obvious in light of recent research conducted by Russell Investment Group. The analysis garnered responses from more than 300 organisations internationally, and indicated worrying times ahead, with the possibility that the return premium for stocks over bonds in the next decade would be as low as 3 per cent. So where specifically are the best returns being found?

Mann believes that the longer investment time horizon of private equity as an asset class closely matches the profile sought by a superannuation investor.

“Private equity allows investors to access illiquid private markets they would not normally be exposed to in traded asset classes,” he said. “They add diversification to a portfolio by nature. Often, the companies that a private equity fund will invest with will be pre-IPO and, in effect, you are accessing an investment prior to the majority of investors.”

Mann continued by saying that in the short-term, particularly in the first few years of investment, it was possible that there would be little or no return.

“But over the long-term returns should be greater, depending on the type of private equity,” Mann said. “A true return on the initial investment does not occur until the company is sold and capital returned. This can sometimes cause a perception of volatility that, in reality, isn’t there.”

Michael Wyrsch, senior consultant at Frontier Investment Consulting, has also seen a growth in the popularity of private equity as an alternative investment.

“Within Australia, the success of private equity has a lot to do with reputation,” he said. “Some managers are on their third or fourth or even fifth fund and, when nearly all are subject to buy-outs, they are developing good trade records. It makes a difference.”

Mann added that private equity markets were also becoming more sophisticated, with emerging sub sectors such as venture capital, management buy-outs, leveraged buy-outs, mezzanine debt, co-investments and secondaries from developed markets across the globe.

“This increases the attractiveness and complexity of private equity as an asset class,” he said.

As for hedge funds, though the recent Russell survey indicated that hedge allocations had increased from 4.3 per cent in 2003 to 6.2 per cent in 2005, not all industry experts believe their apparent popularity to be justified.

Wyrsch believes that where higher investment fees exist, investors should undoubtedly be aiming for higher returns.

“But hedge funds don’t tend to deliver that,” he said. “In reality, though they have lower risk than many other alternative investments, they also have much lower returns. At the moment, there’s less argument for them.”

However, according to Mann, the differences between hedge fund and private equity allocations is representative of both the spectrum of risk available in alternative investments and the need to be careful with the use of the term itself.

“We must be careful not to lose sight of the fact that alternative investments is a catch-all phrase that includes investments across a very wide risk spectrum with different return opportunities,” Mann said. “Venture capital, global macro hedge funds, fixed income arbitrage funds and capital guaranteed funds can all be termed alternative investments.”

Mann said that there now existed a full spectrum of alternative investments that could offer exposure across the entire investment risk spectrum.

“Basically, it is important to realise that alternative investments are not necessarily linked to increased risk,” Mann said.

Traditionally, the broad alternative investment asset class has always been broken down into three main allocations — private equity, hedge funds and direct property. But how are these allocations normally broken down? With Tasplan having recently completed a comprehensive strategic review of its alternative and property investment structures, Cassidy is in a unique position to comment.

“In terms of benchmark allocations, we prefer to identify different types of alternative investments separately,” Cassidy said. “Alternative assets, such as commodities, or very lowly correlated alternative strategies, such as global macro, can be considered separately, as the allocation to these can be funded from all assets in the portfolio. Allocations to alternative strategies, however, may be considered as part of the underlying asset.”

Cassidy continued: “When grouping alternatives, our preference is to focus on degree of underlying risk for level of expected return,” he said.

Looking specifically at direct property, Cassidy said that its key focus was broad diversification as opposed to short to medium-term asset allocation.

“Its illiquidity makes the timeframe to change allocations too long,” he said. “Tasplan’s allocation to core property is focused on stable income rather than high returns, but it is not part of an overall target to alternative assets.”

Commenting on the Russell survey data mentioned previously, Russell Investment Group managing director, institutional investment services, Stephen Roberts stated that real estate, private equity and hedge funds required a skill set and mindset different from more traditional investing. But is that skill set and mindset a barrier to successful investment?

Wyrsch believes that an investor needs to look at the merits of all investments carefully.

“But the principles are the same, regardless. The investor simply needs to have a good understanding of the investment,” he said. “For example, private equity is very much about the people involved. An investor needs to have that knowledge, as well as an ability to negotiate with managers.

“If any barrier exists, it is in terms of resourcing, especially in those areas that are labour intensive.”

Mann agrees, but states that resources dedicated to researching alternative investments are increasing.

“Consultants and research groups in this area have increased, which again reduces the unknown in alternatives as product transparency increases.”

With the Australian share market in its current state of uncertainty, it seems that alternative investments are set to stake an increasing claim on fund allocations. And if that allocation has been redirected from assets with similarly assessed risk levels, then Cassidy believes that the end outcome will be a good one.

“The results will be greater diversification and significantly reduced risk,” he said. “Alternative investments do not have to mean increased risk.”

However, both Wyrsch and Mann are in agreement when it comes to recognising that investor habits are cyclical and, therefore, the allocations enjoying success are likely to be dynamic also.

“Fund allocations go around and come around,” Wyrsch said. “While there are arguments to invest, then people will invest. Over the last few years, investors have been rewarded for taking risks but, at some point, this will reverse.”

Mann added that as different types of alternative investments became mainstream, they will cease to actually be alternatives and new substitutes will be born.

“The investment universe is not static but dynamic and will always be changing to meet the needs of investors,” Mann said. “The share market stability will play a short-term role in the allocation to alternative assets but it will not be a long-term factor. Alternatives are here to stay.”